View: Don’t let short-term panic derail long-term reforms

The lesson is clear. Be prepared for large fluctuations in oil price and the exchange rate.

Can you keep your head when all around your people are losing theirs, and blaming it on you? The reaction of the government and RBI to rising oil prices after August looks panicky and short-sighted now that prices have collapsed.

Brent crude was $62/barrel at the start of 2018. It rose gradually to $70/barrel in August, without causing panic. But then the price shot up to $86/barrel in October. This, along with rising interest rates in the US, caused foreign portfolio investors to exit all emerging markets including India, and stock markets crashed. The rupee went from 63 per dollar in January to 68 in August and 74 in October. The price of petrol, diesel and aviation fuel shot up. Pessimists feared a repeat of the 2013 “taper tantrum”, when rising oil prices plus monetary tightening in the US caused a huge rupee crash and economic slowdown.

Other analysts (including me) urged the government to hold firm and not rush into panicky measures. Let the rupee fall and petrol and diesel go up, we argued, it’s just part of economic ups and downs. Don’t sacrifice long-term reforms — including abolishing politically driven price controls — because of temporary price fluctuations. The economy is far stronger than in 2013, when the trade and fiscal deficits were perilously high, inflation was serious and forex reserves much lower.

The finance minister initially promised to hold firm. But opposition parties naturally seized on the opportunity to blame the BJP for everything that had gone wrong, even though the problem began abroad. With assembly elections in central India coming in November-December, to be followed by a general election in May, the BJP panicked. It cut the excise duty on petroleum products and urged state governments to cut their oil taxes too. It forced public sector oil companies to subsidise petrol and diesel by Rs 1/litre. This naturally meant increasing the fiscal deficit, which deepened the gloom of foreign portfolio investors, who continued rushing out.

The RBI also worried about a repeat of the 2013 debacle. It had already spent $25 billion in April-June shoring up the rupee, and knew it could not afford further erosion of the forex reserves, which would be needed if a full-blown crisis occurred. So, the RBI announced several measures to attract short-term dollars. However, attracting hot money in difficult times is risky, and increases the chances of an ultimate meltdown.

The RBI allowed manufacturing companies to borrow up to $50 million for just one year, against the earlier minimum of three years. Compulsory hedging of dollar loans by infrastructure companies was relaxed to make borrowing easier, even though unhedged borrowing is risky. Rules to check excessive lending by foreigners to a single corporation (which is risky) were relaxed. Tax deducted at source and other conditions were waived for foreigners willing to buy rupee-denominated bonds, increasing the effective cost of borrowing.

Together, these measures were too modest to attract many dollars. By the same token, the measures were too modest to increase risks unbearably. The RBI was less panicky and more measured than the government.

The ink was barely dry on the new rules when oil began crashing, and the rupee strengthened to under 70 per dollar. The world economy is slowing even as oil production is rising, so experts predict stable or falling prices in 2018.

Since the panic is over, the government should speedily reverse its earlier oil price controls. It should restore the old excise duty, and end forced subsidies from public sector oil companies. A politically convenient time to do so will be immediately after polling ends for five state elections in progress. The RBI too should reverse its attempts to attract hot money. It should return to an emphasis on long-term borrowings that cannot flow out easily in a panic.

Some, especially Congress circles, will say that Modi has simply been lucky with oil. Yes, up to a point. But history shows that oil (and the dollar) often fall sharply after a rise. In the 2013 debacle, the rupee went from Rs 55 to Rs 68 to the dollar, but recovered all the way to 58 per dollar by mid-2014. Brent crude fell from $125/barrel in 2013 to just $30/barrel in 2016 before rising sharply again.

The lesson is clear. Be prepared for large fluctuations in oil price and the exchange rate. Keep your deficits low and fundamentals strong, so that you are resilient when markets skyrocket or plummet. Keep a cool head when markets heat up. Never let short-term panic derail long-term economic reforms.